Select articles by Paul Brodsky of Kopernik Global Investors. Paul Brodsky joined Kopernik Global Investors in August 2013, and serves as a Co-Portfolio manager of the Global Unconstrained Fund. From 2006 to 2013, he served as a co-managing member of QB Asset Management Company LLC (QBAMCO), which he co-founded with Lee Quaintance. While at QBAMCO, Paul was a long/short equity portfolio manager responsible for industry-related and macroeconomic analysis, as well as for writing the firm’s comprehensive investor letters. He was also responsible for overseeing all internal QBAMCO administration and operations, and for overseeing the firm’s external service providers for QBAMCO’s US and Cayman investment funds. Through 2006, Paul was the head of investments and operations for Spyglass Capital Trading Company, a firm he founded in 1996, which managed fixed-income arbitrage funds. Before entering asset management in 1996, Paul worked on Wall Street for 14 years for firms including Kidder Peabody, Drexel Burnham, and Piper Jaffray. Paul earned his multi-disciplinary Bachelor of Arts from University of Pennsylvania.

Plastics

Attractive people are more fun to look at than unattractive people. Interesting people are more fun to talk to than uninteresting people. Good looking, interesting people are formidable. We understand why unattractive, uninteresting people would surgically alter their features to become more attractive, but not why formidable people would when it proclaims insecurity which makes them less interesting. This little riff relates to the central macroeconomic thesis explored in this paper: the curious and futile quest to salvage a superficial monetary system by applying the same topical treatments already proven to have weakened its host economies in the first place.

We and others have discussed in great detail the shortcomings, inequities and necessary adverse outcomes inherent in the current global monetary system. Over the last forty years the reliance on unreserved credit creation for nominal growth has shifted macroeconomic priority from sustaining commerce to sustaining finance, which in turn has gutted the potential for real growth and economic sustainability. Global leaders, especially in developed economies, have yet to recognize formally that the grand conceit they have relied upon to assert economic authority – individual and social human incentives can be overcome by serial short-term financial engineering – must one day be reconciled.

Bond traders learn in early orientation that someone assumes the burden of debt not paid, either debtor or creditor. When the debt is big enough, the burden ultimately falls on the creditor. When the debt is sovereign, the burden is usually shared on both sides. No amount of synthesized growth can evaporate global debt. Trying to sell creditors, debtors and taxpayers on the idea that it can be done is a futile and dangerous proposition. Time is not a variable. There is debt that is owed and only money or assets-in-kind can satisfy it.

Very few still pretend the commercial marketplace and financial asset markets are free. Current events confirm we have been trained to think our fortunes are in the hands of politicians, who in turn are caught between competing incentives. Are they supposed to make economic decisions as public servants, per the best long-term interests of the majority in their republics? Or are they supposed to make decisions based on appeasing powerful Interests funding their economies (and often their campaigns) in the here and now? And exactly when are they supposed to ask themselves the deeper question: why aren’t the two the same?

It is our own fault. We expect our politicians to be smart and to protect us but we don’t elect them to be braver than the majority of voters. The process of natural selection for appointed policy makers ensures only the politically astute will fill those positions too. We are left with institutionally weak-minded authority apparatuses in which everyone wants to please and no one is willing to disappoint. For reasons of prioritization, awareness or expediency, they negotiate poorly against more motivated and better trained private sector actors on issues related to government regulation and oversight. This includes economic and financial functions.

Our leaders only discover they are in over their heads after white papers, conniving, obfuscation, horse-trading, confidence-stirring speeches, and, it must be said, lying stop working. The oppression of mathematics takes hold. Only then do they discover that their economic authority is dwarfed by the reality that lies at the foundation of all human incentives: “this is my property; this is the legal contract my counterparty has agreed to; I will exert my rights”. Not to be deterred, ostensibly learned people standing sentry waive their press clippings and accuse independent thinkers of hysteria and contributing to economic recalcitrance. Eventually, when money is too scarce in relation to debts, the 99% begin to reject monetary alchemy and political fiddling. Eggs are eventually broken to make a more sustainable economic omelette and our “leaders” follow the marketplace.

Most of us realize that Europe has arrived at the point of criticality where eggs are beginning to break, but most of us do not yet understand that there is only one economy tied together by a global banking system. Proud politicians, economists, market strategists and journalists in developed economies have cordoned off the crime scene (tsk, tsk, those Mediterranean cultures…). The Establishment’s posture distills down to “if we are confident that our economic problems are fixable then they will stabilize,” undeterred by the reality that the stability they knew was derived from unsustainably centralized control over money, credit (and thus, policy) to the masses. It may be all about the narrative but the plot line the Establishment is pushing is a fiction.

And on the other side, the blogosphere, armed with truth or a convenient version of it, is hurling slings and incendiary arrows at everything and everyone. They warn of economic destruction worthy of epic Greek tragedies and Shakespearian plays. (We admit our pieces have added to the Sturm and Drang, no doubt providing red meat to counter cultures on both ends of the political spectrum. So be it. We are not in the provocation business. Our analysis is fundamentals-based and we don’t charge advertisers by hits or readers by the word.)

The people are siding with bloggers. The great irony is that most of today’s tumult, turbulence, urgency, surreptitious high-level negotiations, would-be defaults, political theater, and reflexive second-guessing in Europe and the rest of the world are off-point. Multi-lateral negotiations may decide who takes what losses and over what period of time they will be amortized, but such negotiations are not being rubber-stamped by the people — just the opposite. The people seem to know that confidence and growth (or austerity) cannot solve what ails us – only money or asset sales can.

Economic fundamentals have not changed throughout the maelstrom. Net unreserved credit continues to overwhelm the functioning of global economies and the global debt trap still requires de-leveraging. De-lever the system and, despite the unavoidable redistribution of spoils that is consequently crystallized, the continuance of economic pain and drama will cease. Few in responsible positions seem willing to concede this point or even to have a public conversation about it. The actions of policy makers indicate they are still unwilling to acknowledge that financial markets are not the commercial marketplace. They are continuing to protect their banking systems above all else. The private sector has so far remained content to entrust its production, wealth, jobs, quality of life and the sustainability of its economies to rotating aspirational public figures intent on achieving personal goals.

Current economic and social backsliding, market turbulence, and the persistent ineptitude of gung-ho career world improvers (and their Keynesian and Modern Money Theory economic stooges), intent it seems on misdiagnosing economic problems and circling their wagons around a tightly controlled financial system few would want to save if they took the time to understand it, makes it difficult to form a reasoned investment view and take action. It is emotionally easy for bystanders to sink into passively relying on hope of something (anything!) happening to avert the inevitable collision. But passivity does not serve the investor.

We will take an alternate tack, distilling current issues down to their essence, comparing and contrasting indisputable economic and financial identities against how they are being twisted and distorted in practice. Our conclusion: the financialization of money today demands the monetization of finance tomorrow. There will be global hyperinflation that peels the skin off your face. It will be mandated first by governments that need new money to satisfy their promises and generated by banking systems that need to be made whole on their deteriorating loan books, not by economists’ notions of increasing private-sector animal spirits or a rise in velocity.

There is good news and bad news, as we see it. The bad news is that all the hysteria in capitals and the press is prolonging the time it takes to properly identify the fundamental problem and apply the obvious solutions. The good news is that, once properly identified and addressed, most of the economic troubles of countries and peoples around the world could (and will) be eliminated in one-fell swoop. Only a managed global devaluation of all major currencies can avoid social unrest. Unlike some trickling out from established ne’er-do-wells, the fix must be one that directly addresses the fundamental inequities inherent in currencies and banking systems and one that resets the financial system to bring the real economy to the forefront. Until then, modern societies will continue to become poorer, less interesting and less attractive.

Proper Identities

The lines separating commerce, money, finance and economics – inter-related yet very different identities – have blurred over the last forty years to the point where they are popularly confused. When we add in vagaries such as governmental monetary, fiscal and trade policies, currency interventions and bailouts, it is easy to understand why “the system” is grossly misunderstood and solutions to its problems elusive. Let’s briefly break this complex system down into its identifiable parts. Below, we give four brief working definitions to serve as benchmarks:

Commerce is a for-profit exchange of something of value between two or more parties. A commercial transaction may settle for goods, services, assets or labor of equal value (barter), or in exchange for money in whatever currency the counterparties agree, such as Dollars, Euros, Yen, gold, wampum, etc. You labor or produce capital goods or capital ideas for us and we exchange our labor, goods, capital goods or ideas, or, a portion of our savings, in exchange. It is simply an exchange of perceived value.

Money is a medium used in exchange for goods, services, assets and labor, a unit of account and a store of value one may save for future consumption.

Finance is the process of exchanging a payable for a receivable, using equity or credit/debt in one side of the exchange. Most of us cannot use equity flotation to finance our businesses, projects, consumption, asset purchases and labor costs, and so the majority of financing in an economy is achieved through the extension of credit and the assumption of debt.

Economics is the study of commercial incentives. In a free-functioning marketplace it would be easy to understand the incentives of commercial counterparties that produce or hinder commercial exchange. Economics, per se, has no goal, such as consistent output growth, low inflation or full employment. (These are political objectives.) It would simply define relationships among commercial counterparties (micro) and the sum of all potential commercial counterparties (macro).

Most contemporary professors, policy makers, bankers and casual observers believe such identities are quaint and inadequate in today’s complex global economy. These people are misinformed.

Monetary Face Peel

Money seems straight-forward to most people, which is unfortunate. In the current global monetary system, “money” is not money – it is mostly electronic credits. We can see this when we look at US monetary aggregates: Base money (M0, currency in circulation plus bank reserves held at the Fed) is about $2.7 trillion. M2 is about $9.6 trillion and consists of currency and checkable deposits (M1) plus household savings deposits, time deposits and retail money market funds. M2 is a claim on base money and there is 3.7 times more M2 than base money.

This means that if everyone wants to retrieve their cash savings at the same time they would either receive about twenty-seven cents per each “dollar” (M0/M2) or, more likely, the Fed would have to print 3.7 times more base money. Put another way, US dollars are levered almost 4:1 before any explicit USD-denominated credit is considered. Thus, US dollars are unreserved electronic credits to savers and unreserved obligations of the Fed (Federal Reserve Notes), literally and functionally.

Does this matter? No, it does not matter from an accounting perspective (in nominal terms) – central banks can manufacture as much base money as they need to satisfy societal demands. However, it would matter greatly to people that want to retain the real purchasing power of their savings. Base money issuance dilutes the purchasing power of each savings unit, much as stock splits dilute the purchasing power of each share. A run on the US banking and money market systems would imply the purchasing power of the US dollar would fall by over 70% (assuming the Fed ignored Dodd Frank and covered money market funds). Again, this would be before even more base money would have to be manufactured so that explicit dollar-denominated debt could be repaid.

What about saving in less-levered money? Gresham’s Law is an old economic principle that basically tells us bad money drives good money out of circulation. Bad money is spent while good money is hoarded. Effectively, the floatation, at par value, of overvalued money gives savers incentive to store their wealth in relatively undervalued money. The natural first place savers look is the competing currencies of other economies that might not be diluting their currencies as much. Today there are no currencies free of central bank management and all global monetary policy makers have incentives to dilute their currencies vis-à-vis other currencies.

Currency exchange intervention by a monetary authority tends to cheapen – not strengthen – the target currency’s purchasing power against others, which allows its economy to manufacture goods more cheaply than those produced in an economy with a stronger currency. This in turn keeps the domestic economic factors of production mobilized and increases profits to the exporter once foreign sales are converted back to the local currency.

A net importer seeking to weaken its currency (e.g. US) would thus export inflation by sending diluted money overseas in exchange for goods and services. A net exporter endeavoring to maintain a weak currency imports inflation (e.g. China, Japan). Domestic users of a politically-engineered diluting currency will not generally notice the decline in the purchasing power of their wages and savings as long as their economy is exporting inflation and they have credit available with which they may use to consume. Credit growth synthetically increases their wages, consumption and “savings” above where it would be in a naturally-functioning economy.

The continual issuance of unreserved credit, surreptitiously in the form of “money” (i.e. unreserved bank deposits), synthetically drives the price level, output, employment and “savings” higher. This is not at this point sustainable purchasing power, however, because a unit of credit is only a claim on a future money unit that does not yet exist.

So then, monetary authorities first create the appearance of more money in the system than there actually is until, ultimately, the marketplace forces them to satisfy those monetary claims by inflating the base money stock. This inflation then reduces the purchasing power of the “money” already in circulation.

Financial Nip/Tuck

Finance is also straightforward, as it appears in textbooks, but not so simple as currently practiced. All credit/debt transactions are not created equal. If you loan us $10,000, then you would actually have to debit your account by $10,000. Doing so would mean you would be depriving yourself of that spending power for some period of time. We would negotiate an interest rate and a maturity by which time the financing arrangement would be extinguished. If it were a successful financing you would have built your capital by helping us build our capital. Otherwise we would both suffer the consequences of the risks we took.

Most of us do not borrow money directly from each other. Instead we borrow money from banks or we use a bank as an intermediary to find us willing and fully-funded lenders (i.e. unlevered bond investors). It is conceivable that such financial institutions could behave in a similar way as you and we did in our example above – they would lend only to the extent of their accumulated reserves and would expect their loans to be extinguished after they served their purpose. However, banks are fractionally-reserved, which means they lend more money than they actually have in reserve and they may do so almost without limitation.1

As the discussion of money above suggests, a person or business that goes to a bank to borrow money does not borrow money at all. In a credit transaction, a debit is assigned to the borrower and the bank simultaneously creates as an asset the loan receivable). No money changes hands. (Indeed this is how banks lend money into existence, and in so doing how they inflate their economies: banks make loans by creating unreserved credit from thin air => unreserved credit ultimately demands actual money to repay the debt => monetary authorities must ultimately create base money to service debts => purchasing power declines.)

Modern banks are effectively in the business of naked currency shorting, while central banks are symbiotically in the business of ensuring that banks can profitably cover those shorts over time.

The current global system of money and credit is indeed a “fiat system”, as hard money advocates derisively claim, yet not as well known is that: 1) governments have let their banking systems enjoy control over their currencies and, 2) fiat control over currencies gives fiat control over commerce. Therefore, all public and private commercial entities must bear the risks assumed by their banking systems, which is particularly odd because both private banks and central banks are for-profit entities in the private sector. There is no such thing as a private commercial exchange that our banking systems do not influence.

Consider that credit created by banking systems flows through to capital-building enterprises, wages, earnings and thus “savings”. A portion of this credit finds its way into investment (as equity), and a portion finds its way back to the banking system (M1 and M2). Thus, the balances most economists and financiers refer to as “savings” and “retained earnings”, entries that all of us generally think of as “wealth”, are in reality unreserved bank system credit. All economic actors are borrowing their money from the banking system, in effect, financing their lifestyles.

We find ourselves discussing money again when we intended to discretely identify the true financial system. This is because not only are stocks and bonds financial assets, the very “money” in which they are denominated is too. It is borrowed, as we discussed above. We, as economic participants, use banking system-manufactured electronic credits as our medium of exchange in commercial transactions, to pay our taxes and, for many, to save (store our wealth). When banking systems can no longer find outlets (consumption, capital expenditures, home borrowing, financial asset speculation, etc.) for the explicit credit they create, the financial system begins to de-leverage. This includes most of what today is perceived as our “money”. How can our “money” de-leverage? It does so in purchasing power terms (or else, via bank runs!).

What we are seeing today is economic cheerleaders trying to get M2 “savers” to leverage their cash further (as a theoretical example, putting down a big chunk of the $9.6 trillion as down payments for home purchases and using the rest as the basis for increasing consumer borrowing). Think of the economic stimulus this would engender. Now think of what would actually be occurring. Money that is already mostly credit would be going to create explicit credit, half of which we would call “home equity”. The attendant rise in home values and consumption would then create more jobs and wages and income and consumption (and more electronic credits). Leveraging would start anew. This exponential leveraging does not describe a preposterous theoretical future — it precisely describes our most recent past.

The amount of debt in an economy theoretically does not matter. Why? Because people and businesses may owe any amount to each other and if they can’t find the money then they can repay their debts with assets. However, in modern societies creditors are not kings and cannot take too much property in lieu of money. You may pay back the mortgage on your home by sending your bank the keys, but everyone on your block or town cannot. Why? Because in the absence of subsequent base money stock growth, the banks would have no one to whom to sell the houses then, right? There would be no “money” left.

Greece could pay back its debts to European banks tomorrow by selling China a few shipping ports or tonnes of gold in exchange for Euros. Will it? Nah, it knows the Euros it owes the banks are baseless, as do the banks, as do the Chinese. In the end, what matters is that banks are repaid in nominal currency so that the fiction is perpetuated. Banking systems manufacture credit, call it “money”, and control the global monetary system.

And so finance is theoretically a right and noble endeavor but is a messy thing in contemporary practice because credit and debt are not reserved and, by clever design, never extinguished. Finance requires optimism and confidence, whether or not such confidence and optimism are warranted in real terms. To keep the financial system going, consumers, businesses and governments must be willing to assume more outright debt so that the banking system can convince its depositors not to want their “money” while the political dimension tries to convince everyone that their electronic credits will keep their purchasing power. It is an untenable set of conditions in real terms but very sustainable in nominal terms…as long as we ephemerally assign par value to the vapor in our bank accounts.

Economic Growth Augmentation

Economics may be the study of commercial incentives but it is impossible to understand such incentives in a system without monetary and value anchors. Notional baseless currencies and fractionally-reserved financial systems allow for the ongoing latent potential for extreme money growth, infinite credit growth (or contraction), and necessary policy management and intervention that must accompany them. Together, these forces push around price levels and commercial incentives, which, in turn, give rise to the perceived need for more reflexive exogenous intervention in commercial exchange. Thus, economics as it is thought of and practiced today is much more a political construct than the study of commercial incentives.

The natural primacy of commerce has been subverted over the last forty years by its derivative functions, money and finance, to the point where all three are now dysfunctional. Credit-based consumerism is not a sustainable economic model when debt is not extinguished. The global economy is in the midst of a highly leveraged debt trap where banking is omnipotent, credit is infinite, money is actually scarce, and economics has become the study of political will. There can be no honest search for economic balance and real value in assets until these functions are properly identified and reconciled. A monetary nip here, tuck there… after forty years the global economy resembles the synthetic facade of a serial Botox victim.

The Wayward Emphasis on Growth (or Austerity) as an Economic Fix

The one constant among political economists advocating for virtually all points along the political spectrum is that growth is always good (though they often differ as to how it should be best achieved). In fact, the entire notion of growth as a sustainable economic goal is frivolous. The function of any economy no matter how simple or complex is to economize, to fund and distribute resources and the factors of production efficiently. (This is not, in itself, a political posture. It defines a capitalist economy.)

Unabated real output growth at a rate higher than the birth and immigration rates plus innovation is a fallacy. Real growth is a by-product of population growth, commercial productivity, and innovation – not money and credit growth. As we are seeing presently, juicing nominal growth via credit growth ultimately leads to real economic contraction: credit growth must eventually lead to base money growth, which must lead to rising prices of goods and services, which in turn leads to a loss of consumer purchasing power (as wage and credit growth ultimately lag), which further leads to lower consumption and job losses, which in turn leads to real economic contraction.

All agree that global economies are out of balance presently. Most agree that this lack of economic balance is best captured in high and rising Debt-to-GDP levels (see graph above and chart below). The political debate surrounding this is whether it would be preferable for output growth to rise or to let credit and debt deflate. Everyone has an opinion but the problem itself is framed incorrectly.

We do not see the value in comparing Debt to GDP. In a global economy that uses baseless money as its currency comparing debt load to output is an illogical predicate in judging solvency. Debts are claims on currency units. They are denominated in money — not the widgets produced, sold, consumed and counted in GDP. While the propensity to roll and expand existing debts is likely correlated to real output growth via some animal-spirits driven transmission mechanism, GDP growth does not create the only medium (base money) that can extinguish debt. Only central banks can create base money to repay existing debt. This is a critical point for investors, policy makers and economists to understand.

Expanding output in a sterile base money growth environment only leads to nominal price declines for said output. This means it is mathematically impossible – not improbable, but impossible — and therefore unreasonable to expect, that the right measure of fiscal stimulus, tax-adjustments, debt-rollovers, and trade controls could de-leverage the system and lead to a self-functioning global economy over any amount of time.

A debt-to-income ratio may work for individual economic participants, such as a company or a household, but does not work for an aggregate economy. If one produces more to earn more currency in exchange for his production then his creditworthiness improves. However, this exchange demands that the creditworthiness of some other participant in the system must decline in kind. So there is a fallacy of composition at work when we apply this reasonable discrete analysis to the broader system.

If an aggregate economy begins to fund and distribute goods and services with diminishing utility, it should shrink until its factors of production shift. Growth as a goal (and achieving it on the back of debt-funded consumerism) is a silly and dangerous presumption that contemporary policy makers, academics, Nobel Laureates, Street economists and investors take for granted. Today’s economic growth strategies are nothing more than leverage schemes that reward leveragers.

The global economy is suffering from a financial problem, not a commercial exchange problem. Good fiscal policy can bring consumption forward, thereby creating nominal growth, but it would be at the expense of real growth (adjusted for unreserved credit production that demands future money production). No amount fiscal stimulus that might engender current output growth and no amount of confidence building that promotes new credit issuance and debt assumption can de-lever whole economies. We simply can’t get there from here.

Losing their Religion

We do not form opinions and make proclamations in a vacuum. Dissenting opinions challenge and fine-tune our views. Martin Wolf, the mother of all high-profile Keynesian economic journalists, wrote a recent piece in the Financial Times; “Thinking through the Unthinkable”,2 in which he, along with the aid of an unpublished paper he read by Nouriel Roubini, (a regarded economist), struggled to find economic solutions for Europe’s conundrum. Both seemed to agree that the only hope for salvation can come from the outright acknowledgment that flows matter more than stocks, (how, when and where money flows rather than the quantity of it), mixed with well-planned and well-timed fiscal initiatives. Part of the article dealt with the shortcomings of forced austerity, with which we would agree. Wolf concluded that if the eurozone is to survive at all, “potentially solvent countries would have to be financed and the eurozone would grow its way out of the crisis.” So print the money, they argue.

We agree that the ECB will finance weak countries but we think the simple act of doing so makes it that much more unlikely that there can be any “potentially solvent countries”, including Germany and France. (Keep in mind that even though it is a significantly smaller country, Italy has more debt outstanding than Germany.) Wolf and Roubini seem to be clinging to the idea that growth can repay debts (flows matter more than stocks). The prescription for an enlarged heart is not telling the patient he needs to double in size. And finally, we respectfully disagree with Wolf’s assertion that “hyperinflation could be avoided with some external support” (he provided no details here). Whoever is doing the financing – European banks, the ECB, the Fed, you or we – would have to agree to ignore our most fundamental incentives so that Greeks and Italians don’t have to ignore theirs.

To be fair, Wolf did not seem all that enthused about framing the situation as salvageable. Come on, Martin, stop with the rhinoplasty. Unshackle yourself from false patriots and give us the benefit of your keen and potentially independent mind. Declare the system should be scrapped and give us the real solution. We know you know what it is. Let her rip. The ladies will throw roses to the first credible economist out with it.

FOFOA

Speaking of independent analysis, we would like to congratulate a blog called FOFOA, which stands for “Friend of a Friend of Another” on posting a piece November 6 called “Moneyness.” Frankly, we do not know who writes it but provenance is not an issue with us. The facts are accurate and in context, the logic is pristine, the tone is even and the assertions are reasonable. The blog takes no advertisers. As far as we can tell, it’s a smart man or woman seeking to understand the true forces behind economics and finance. (Of course, it doesn’t hurt that we seem to share many of the same sensibilities and outlooks.)

We were finished with the economic and financial identities section of this piece when we read it, which was a good thing because FOFOA begins much the same way — by going back to basics. Even though he (we’ll make that presumption) also writes for a sophisticated reader, he must have also felt this was necessary given the wayward paths being taken by high-profile pundits.

We enjoyed a section he wrote refuting the practical validity of MMT (“Modern Money Theory”), which we had also rejected prior to FOFOA’s exploration of it. MMT treats money as accounting entries (correctly, as it is today) and essentially argues there should be an overriding US economic imperative to continually post credits and debits as needed to fund capital building projects and economically stimulative programs. MMTers believe there would be no negative consequences from doing this because shortfalls and disequilibriums that arise, no matter how large, could be summarily replaced and channeled for the public good.

While we agree that money in its current form is just an accounting entry and we agree with MMTers that bringing accounts into balance is easily done, we do not think global asset markets and trade partners would continue to endorse a currency with continually diluting purchasing power. There would be massive transfers of perceived wealth which would greatly reduce the global value of US dollar denominated claims vis-à-vis scarce resources and non-American financial assets. If the world used MMT as its currency system, then it would completely transfer wealth and the power over where it is distributed to the state or banking system. So we are dismissive of MMT as a practical and sustainable monetary model. Like the current system, an MMT system would run counter to the natural human propensity to save, which serves to equalize power among governments and the people they serve.

FOFOA detailed MMT’s shortcomings and used it as a necessary lead-in for his coup de grace: the US government’s inability to fund itself over time by issuing debt money. FOFOA introduced a very salient issue into the conversation: the US government’s addiction to US dollars and why this addiction will ensure that the US government itself will create a “catastrophic loss of confidence (in USDs) that is hyperinflation”. The logic is as follows.

For 30 years, US domestic consumption has been subsidized by foreign-supported trade deficits, in turn developing a US government (USG) addiction to essentially free goods.

At the same time, US productive capacity has dwindled to the point where it is insufficient to satisfy domestic private sector demand and certainly insufficient to support the USG’s addiction.

It is economically and politically impossible to impose sufficient taxes on the US private sector to keep the US government’s goods addiction going.

The only way out for the USG is to fund itself through base money creation. By doing so, the USG will be competing with its private sector and with other economies doing the same thing with their printing presses in an effort to acquire importable goods.

The global private sector, competing with global governments, will have to pay substantially increasing prices even though it cannot manufacture its own currency.

Confidence in all baseless currencies will be lost.

We see this occurring today. The US government is expanding while the US private sector is contracting. Why haven’t we seen substantial inflation assert itself yet in consumer prices? FOFOA quotes Austrian school economist Henry Hazlitt:

“What we commonly find, in going through the histories of substantial or prolonged inflations in various countries, is that, in the early stages, prices rise by less than the increase in the quantity of money; that in the middle stages they may rise in rough proportion to the increase in the quantity of money (after making due allowance for changes that may also occur in the supply of goods); but that, when an inflation has been prolonged beyond a certain point, or has shown signs of acceleration, prices rise by more than the increase in the quantity of money. Putting the matter another way, the value of the monetary unit, at the beginning of an inflation, commonly does not fall by as much as the increase in the quantity of money, whereas, in the late stage of inflation, the value of the monetary unit falls much faster than the increase in the quantity of money. As a result, the larger supply of money actually has a smaller total purchasing power than the previous lower supply of money. There are, therefore, paradoxically, complaints of a ‘shortage of money.'”

FOFOA rightfully seizes on the last line of Hazlitt’s quote, specifically, “complaints of a shortage of money”, to make the hyperinflationary feedback loop complete. Money must be manufactured or else all economic function stops. We think the thing to take away from FOFOA’s post is that animal spirits in the private sector are not necessary to drive inflation or necessary for hyperinflation. Indebted governments are capable and will have incentive to crowd out the private sector from obtaining money with which to service its debts.

Our Buried Lead – Unreserved Bank Assets

We have warned for years that the fundamental issue facing the global economy is that the ratio of debt-to-money is irreconcilable. There simply is not enough money. Add in the necessary crowding out that government demand for money may impose on private sector debtors and it is easy to envision substantial (and popular) base money manufacturing for all ending in hyperinflation. But there is one problem here: the US government does not literally manufacture base money – the Fed does.

Does this matter? We don’t think so. The Fed is a private company purported to be literally owned and controlled by the largest banks in the US and the UK. It has a monopoly US dollar printing granted to it by Congress in 1913. While Congress can revoke its charter (we think) if it feels Treasury’s need for base money should take priority over the banks, there is no logical reason to think that Congress would be any more willing in the future to act quickly on Treasury’s behalf than it has been already, when its alternative is acting on its board members’ behalf.

We do not pretend to have insight into such off-the-grid conspiracy theories and potential occurrences. If we presume Congress gives Treasury priority for new base money without hesitation (because congressmen want to be paid?) by revoking the Fed’s charter, then we still do not think there would be a material difference in inflationary outcomes. Base money today is created in a split second with a keystroke (Voila! $2 trillion for JPM, $1 trillion for GS…). The price level will rise either as the government drives prices higher or bank balance sheets are made healthier, which in turn would promote a new leveraging cycle (money multiplier, velocity, etc.).

The more we think about the risks in the global economy the more we realize it all comes down to unreserved bank assets – the mark-to-market value of total bank assets less base money. This identity would quantify the intrinsic leverage (base money short position) in the transmission mechanism of the global monetary system.

Try to find data for unreserved bank assets. You won’t find at the Fed, BIS, IMF, World Bank or any other banking system authority. It is nowhere to be found online. We asked bank analysts, to no avail. Different domains have different reserve requirements, but this should not hinder an assumption-based metric (Basel II or Basel III?) that would identify clearly the driver of global bank demand for money. (Send it, if you have it.)

So we went looking for plain old global bank assets. According to International Financial Services London, “assets of the largest 1,000 banks (worldwide) grew by 6.8% in 2008/2009 (June to June) to a record $96.4 trillion.”3 IFSL further reported that assets of the largest 1,000 banks had more than doubled in the five years leading up to the start of the credit crisis in 2007.” US bank assets may be found at the St. Louis Fed’s website. The National Information Center publishes a table of the assets of the 50 largest US banks, displayed below.4 This sampling will adequately serve our purpose.

Total assets for the 50 largest US banks were about $14.9 trillion as of June 30, 2011. We can see from this simple sampling that the US fractionally-reserved banking system is literally insolvent every day it opens for business. US banking system cannot contemporaneously pare-off its assets (assets upwards of $15 trillion) with its liabilities (deposits – about $9.8 trillion for depository institutions) and with base money ($2.7 trillion).

Does the amount of bank reserves relative to the aggregate size of bank assets matter? No, not until depositors, bank shareholders, creditors and counterparties (or any one of them) acknowledge the discrepancy and begin to care about it. Why would they ever begin to care about it? Because: 1) wage earners who place their savings in banks as deposits do not want to labor for free, and 2) investors borrowing to hold assets (directly or indirectly by borrowing other assets) do not want their collateral taken from them. (This issue was made palpable for all to see this month when MF Global may have used customer assets to fill the hole in its balance sheet.)

On a macro level, the financial system must continually expand its collective balance sheet or else face implosion (like Ponzi or Madoff). As long as there is demand to borrow, banking systems will dilute the purchasing power of their economies’ currency by creating unreserved credit. The credit is cycled through economies and, at first expands them, builds capital, and unleashes animal spirits. As time goes by newly created credit produces less and less economic expansion. Eventually, any new credit created actually works to contract the real economy. How? Because past credit and debt was never extinguished and grew at a far higher rate than the stock of base money.

This is precisely the issue in Europe today. As with US dollars, there is a dearth of Euros relative to debt denominated in those currencies. So when the people of Greece and Italy have to decide whether to repay their Euro-denominated debts to banks and bond holders, they are really deciding whether to default on debt that cannot be repaid without the issuance of new credit by their creditors (rollover the debt). The only other way for them to repay their debts would be to export goods and services in exchange for Euros, which by definition would reduce the total stock of Euros available to other Euro denominated nations, which in turn would make “stronger” eurozone economies less able to service their debt. Again, in aggregate it cannot happen. The problem is a scarcity of base money, not real economic growth. (Until, at least, the latter begets system de-leveraging. We are not at that point yet.)

From Theory to Practice – A Framework for Investing in a Systemic Deleveraging

We estimate the US banking system is effectively leveraged almost 6 times (bank assets to total base money). To fully reserve it in order to regain public confidence in the currency, the Fed would have to grow the monetary base to about $15 trillion. This would effectively replace all bank deposits (“checkbook money”, as Rothbard would say) with base money. The banking system would then be completely de-levered.

Going into this adjustment, the prices of assets and elastic goods and services propped up with leverage would be pressured downward to find some notion of intrinsic value, while assets, goods and services not propped up with leverage would revert upwards to the same notion of intrinsic value.

Envision a see-saw where the most unlevered asset (gold) is on the ground and the most levered assets (certain real estate, etc.) are up in the air. The fulcrum of the see-saw is the total perceived stock of money because it remains unchanged. (Today, the markets incorrectly do not differentiate between a $100 Federal Reserve Note in hand and a $100 bank deposit, which means our whole pricing structure is built upon this fallacious assumption. Given the 6 to 1 bank leverage noted above, the intrinsic value of a bank deposit is about 17 cents on the dollar.) The see-saw as it stands today should generally be populated from the ground-up in the following manner:

Gold

Consumable commodities

Wage rates

Finished goods

Base money + bank deposits (fulcrum)

Levered assets

Completely deleveraging the banking system would provoke a massive transfer of relative value from #6 to #s 1-4. To identify how the world’s relative pricing/wealth structure would change as a result of this deleveraging, one would have to define component buckets for each of the above (1 – 6), and then create a schedule whereby the two ends of the outcome spectrum are defined by:

Today’s pricing spectrum.

Tomorrow’s pricing spectrum in the event of a full deleveraging (i.e. base money grows to $16 trillion but every dollar of base money created is consumed by the banking system to retire all unreserved deposit claims at par).

Having defined the two extremes, then one might simply show a 25%, 50% or 75% move from today’s pricing spectrum to tomorrow’s. Whether or not the changes from 1 through 6 would be linear are of second-order importance for the purposes of this analysis. Perhaps the deleveraging process would simply be the mirror image of the path of leveraging price patterns that preceded it?

So… there is no rational reason to expect lasting chaos and epic changes — not when all that is necessary to reset the global economy is printing a bunch of money, not when there’s nothing to prevent it from happening, and not when politicians (and yes, certain asset holders) will win big and/or dodge catastrophic loss from doing so.

We were inspired to write this piece after reading recent comments by two of the world’s largest and most highly regarded active macro investors. Both were fairly pessimistic about asset prices and the broad economy because, in a nutshell, they ultimately doubted that the magnitude of output growth and de-leveraging would be sufficient to provide enough thrust to give US and global economies adequate momentum to break free from the debt trap. We believe they are not considering or overlooking fundamental identities discussed here that, when considered, define a clear path for asset selection, and that actually engender overall economic optimism.

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Select articles by Paul Brodsky of Kopernik Global Investors. Paul Brodsky joined Kopernik Global Investors in August 2013, and serves as a Co-Portfolio manager of the Global Unconstrained Fund. From 2006 to 2013, he served as a co-managing member of QB Asset Management Company LLC (QBAMCO), which he co-founded with Lee Quaintance. While at QBAMCO, Paul was a long/short equity portfolio manager responsible for industry-related and macroeconomic analysis, as well as for writing the firm’s comprehensive investor letters. He was also responsible for overseeing all internal QBAMCO administration and operations, and for overseeing the firm’s external service providers for QBAMCO’s US and Cayman investment funds. Through 2006, Paul was the head of investments and operations for Spyglass Capital Trading Company, a firm he founded in 1996, which managed fixed-income arbitrage funds. Before entering asset management in 1996, Paul worked on Wall Street for 14 years for firms including Kidder Peabody, Drexel Burnham, and Piper Jaffray. Paul earned his multi-disciplinary Bachelor of Arts from University of Pennsylvania.